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Russell Napier: "Let’s Ask Dr Copper If China Can Reflate The World"

The Solid Ground has long speculated that, one day, the great reflation of the world will be driven by China and not the USA. Many will argue that the great reflation began in June 2009, when US GDP bottomed, but your analyst prefers to measure any successful reflation with reference to the global debt to GDP ratio. Only by reducing that ratio from record highs can any reflation be said to be undoing the structural risks of depression and deflation inherent in any highly geared economy. Globally credit to the non-financial sector as a percentage of GDP reached 218% in 4Q 2017 from 180% in 4Q 2007, at the peak of the last business cycle.

This is not a successful reflation. Nominal GDP growth remains far too low, relative to the growth in debt, despite the now prolonged economic recovery. The structural risks from too high a debt and too low a cash flow are greater than ever. Now that the world’s second largest economy is attempting to reflate, can this finally bring the inevitable inflationary solution to the high debt problem?

There were many causes of the GFC but primus inter pares was the then record high level of debt to GDP. The chances of a recession becoming a depression are much higher when an inability to service high debt burdens threatens to depress the value of bank assets below the value of their liabilities. When that happens a bank’s capital is expunged and, at least in theory, a major contraction in its balance sheet and a destruction of money should occur. That destruction of money causes the debt deflation and depression that will always be a clear and present danger when debt levels are too high and declining cash flows in any recession threaten default.

In previous quarterly reports The Solid Ground has looked at the limited, objective measurements for key countries that tell us when too much debt is genuinely too much debt. With very few exceptions, notably Germany, there are few countries undergoing the reflation that brings debt to GDP ratios to levels well below their levels of 2008 - when a global recession came close to becoming a global depression. In particular, China has seen a failed reflation with its non-financial debt to GDP ratio rising from 145% in 4Q 2007 to 256% in 4Q 2017. The Solid Ground contends that this failure has been enforced by an exchange rate policy that must now be abandoned to begin a successful reflation and degearing of China. This major switch in policy, now recently launched, will have profound impacts on global financial markets.

Long-term readers of The Solid Ground will know the importance in the difference between bank debt and non-bank debt. The expansion of bank debt creates debt and money while the expansion of non-bank debt is simply the creation of debt. Across the world the disintermediation of the banking system has allowed the creation of ever more debt, outside the banking system, without the creation of money. This has some benefits as it has allowed debt to grow without the boom in money supply that would almost inevitably lead to high inflation. However, it also has many downsides because low money supply growth keeps nominal GDP growth low as non-bank debt burdens grow ever higher. The result is higher debt levels relative to cash flows and a more fragile financial system. These higher debt burdens do support higher levels of economic activity, but they primarily support ever higher asset prices. Over the past few decades the owners of assets, in China and elsewhere, have been the key beneficiaries of this new form of debt laden growth.

The surge in non-bank lending in China has clearly played a key role in the rise of the country’s debt to GDP ratio and also its asset prices. It has also played a role in keeping GDP growth higher than it would otherwise be but, according to this analyst, not as high as it would have been had all the growth in debt been accounted for by the growth in bank debt. What China needs is higher money supply growth and higher nominal GDP growth, and this cannot be provided by a surging non-bank debt growth. At the heart of this surge in debt, and decline in broad money growth that pushes the debt to GDP ratio ever higher, is the wrong monetary policy. Exchange rate targeting has taken China to a dangerous place and must now be abandoned.

In the last Solid Ground Fortnightly the need was outlined for China to move to a more flexible exchange rate. The exchange rate management policy forces the level of broad money growth in China to relate to the condition of its external accounts. With the deterioration in those accounts in recent years, it has been necessary to keep bank credit growth, and thus money supply growth, lower than before to prevent a rapid deterioration in the external accounts through a boom in imports. Into the vacuum of relatively more controlled growth in bank credit stepped the so-called ‘shadow banking system’ - that system which creates debt without creating money. While the debt so created does have a positive impact on economic activity and particularly asset prices, it does not have the same powerful impact on nominal GDP growth as the expansion of bank credit and thus money.

It’s a form of growth that fits with China’s exchange rate policy as the deterioration in the external accounts is more muted, given the low level of broad money growth. So the exchange rate policy has resulted in a constraint on the growth of money, but not in the growth of non-bank debt. As long as monetary policy remains constrained by an exchange rate target, there are only two options for China:

a major improvement in the country’s external accounts that permits higher levels of broad money growth and inflation.

a painful deleveraging in which debt contracts faster than GDP

Of course, the more bullish outcome is possible. It is, however, unlikely to occur through a current account improvement, unless driven by a collapse in Chinese GDP growth and import growth and this would clearly be to the detriment of Chinese and global growth. However such an improvement in the external accounts can occur by a major improvement in the capital account. Forecasting capital account conditions is notoriously difficult and, as we all know, China has been managing its capital account aggressively in recent years in an attempt to reduce capital outflow. It is thus tempting to think that the capital account is at best stable and could probably deteriorate further if the population’s desire to reduce their RMB exposure reached even higher levels. However, it could go the other way, particularly if China was to liberalise its financial system and permit massive restructuring of SOEs. Such a move could both retain and attract capital to China. Similarly a major liberalisation of the Chinese bond market, allowing material foreign ownership, could also act to create a major capital account surplus. We will have to wait to see whether such liberalisation actually occurs with positive impacts for the condition of the external accounts, broad money growth and nominal GDP growth. In this scenario China can combine a stable exchange rate with the much higher levels of nominal GDP growth necessary to reduce its debt to GDP ratio.

Your analyst remains sceptical regarding the prospects for liberalisation as it would involve the Chinese Communist Party giving up control of key levers for the control of interest rates and credit. It could happen, but it is not probable. And the more China is threatened by outside forces, the more likely it is that the Communist Party of China responds by guarding more closely its levers of power. Short of such an improvement in the capital account, China risks a painful forced deleveraging as broad money growth and nominal GDP growth continue to decline. That option is one few politicians would countenance, whether elected or un-elected, and thus it is much more likely that the exchange rate targeting regime is abandoned. All this points to a change in monetary policy that would allow China to inflate away its debts. No such policy can be pursued, in the absence of a major capital account improvement, without a lower exchange rate.

Short of such liberalisation, bringing a major improvement in its external accounts, China’s exchange rate policy constrains it to continue to create low money supply growth and low nominal GDP growth and thus an inability to reduce its debt to GDP ratio. Even during the recent so-called period of deleveraging, China’s non-financial debt to GDP ratio has only stabilised at 256% of GDP through the course of 2017. To bring down the debt to GDP ratio China needs to create more broad money growth and more inflation, but the exchange rate policy is delivering a record low growth in broad money - just 8% year on year in June 2018. China needs to boost the supply of broad money if it is to relate away its debts and to do this it needs more bank lending and less lending from the non-bank system. As higher broad money growth and higher nominal GDP very probably lead to a deterioration in the current account, then the current exchange rate policy hinders such a reflation. The declines in the RMB exchange rate in recent weeks signal that China’ s policy makers recognize the constraint and are moving to a new policy setting with a more flexible exchange rate.

The weakness of the RMB in the past few months tells us many things, but most importantly it tells us that China has conceded that a genuine reflation, one that reduces an escalating debt to GDP ratio, is now more important than exchange rate stability. By moving away from exchange rate targeting, the regime is free to boost bank credit growth and money growth with a view to generating the high nominal GDP growth that can bring debt to GDP levels lower. In this process strict controls have to be kept upon non-bank credit to ensure that the lower real interest rates, necessary to inflate away debt, do not encourage further borrowing from non-banks. As The Solid Ground has noted many times before, any policy that inflates away debts has to have an element of financial repression involved in it. There are numerous long-term implications from financial repression for investors, but most obviously it produces poor nominal but particularly poor real returns for bond investors. Enticing foreign algorithms to buy Chinese bonds may be still possible in a period of greater repression, but encouraging a human being to so commit capital is surely a challenge.

This is a very different policy mix for China with a more flexible exchange rate, and a credit policy likely to produce higher nominal GDP growth while constraining the flow of non-bank credit to assets. Can this new policy mix be good for the world and produce a global reflation?

In the 3Q report The Solid Ground will look in detail at whether China’s changing policy mix can be a net positive for the world. In the short term we have already seen the initial reaction to the move to a reflation is a lower exchange rate. That lower exchange rate creates many challenges to those who compete with the world’s largest exporter of goods. China might use the weakness to cut the USD selling price of globally traded goods, producing not only deflation but solvency issues for those it competes with.

However, as discussed in the last Fortnightly, a move to reflate by China would almost certainly take the country to a current account deficit at a time when key developed world countries seem determined to run current account surpluses - a major positive for global growth. There are many other pluses and minuses from this new policy mix. So how do we weigh them up to assess whether the net impact is reflationary or deflationary? Your analyst suggests that in the short term the best indicator to watch to establish the net impact is the copper price.

Much has been written about the ability of Dr Copper to reflect the outlook for world growth. Indeed in Anatomy of The Bear this analyst found it to be one of the few reliable indicators, at major market bottoms, that deflation was ending and a reflation was beginning. Of course, no indicator is perfect but in general the copper price provides a good lead indicator to the market’s assumptions in relation to global growth. So how is it responding to the change in the policy mix in China? When it weighs the negative impact from an RMB devaluation and the positive impact from a Chinese reflation, does it respond positively or negatively? While there have been no conclusive moves in the copper price, the current indications are more negative for global growth than positive.

Investors should continue to watch Dr Copper to assess whether these key changes in the world’s second largest economy are the beginning of that new world of a true reflation. It is a world where a major Chinese reflation can lead to a level of higher world nominal GDP growth and finally a decline in the world’s record high non-financial debt to GDP ratio. This is a world of much higher inflation with very profound implications for asset price returns.

Your analyst still remains more in the deflation camp than the inflation camp. There are any number of key problems facing global growth, enumerated at length in various quarterly reports, that suggest our record high debt to GDP ratio can once again risk turning a recession into a depression. However, China’s move to reflate, albeit with a more flexible exchange rate, and the recent pick up in bank lending in the US (previously covered in the late June Fortnightly) are important changes that investors need to watch closely. How Dr Copper trades in the next few weeks and months will provide a critical insight into the net impact of these key changes. Your analysts expects a lower RMB combined with a lower copper price. Time will tell.